Friday, March 11, 2005

Be Careful What You Ask For...

Joseph Quinlan, the Chief Market Strategist for Bank of America, came out with a good piece of research and writing this week. The basic premise of the report can be summed up by this paragraph:

"While rising world energy prices may be an unpleasant fact of life, there is a bright side to the spike in oil prices. Oil producers, flush with cash, recycled record sums of petrodollars back into the United States last year, helping to underwrite the debtor status of the United States."

The research report made me think even further. Oil prices increasing beyond historic highs have acted as a brake on world economic activity. Higher long rates should be doing this but now don't have to because of expensive oil. In other words, higher oil prices act as a replacement proxy for higher long term interest rates.

What further buoys the bonds is the big money fatcat foreign oil producers taking with one hand while giving with the other. If oil were to drop in price to $25 or so, bonds would collapse and long T-rates soar, causing a cascading real estate crash the likes of which have not been seen by anyone living today. The stock market could be dumping ala 1974, and there would be no place to hide, except TBills and Zero Coupon Bonds. I believe the stock market prefers oil prices not too hot and not too cold. The same goes for inflation.

The Feds have their hands full trying to warm the porridge just right for Goldilocks who can be, and often is, an ungrateful and fickle brat. Everyone is complaining about the high oil prices, but be careful what you wish for.

Just a few thoughts that have been going through my brain lately. Let me know what you think.

Additional and Clearer Implications: If oil stays the same or rises further, rates should stay low. If oil comes back off, interest rates should rise.

I would bet more on the rates staying lower. That would reflect a flattening yield curve as short-term rates rise steadily. An inverting yield curve will tank the market.

P.S. Remember that this is just a theory. Come up with some of your own and post them in the comments section. Dust off that keyboard and write some of your thoughts down.

Best Regards,

The Soothsayer of Omaha


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